National Review, April 3, 2013 (April 22, 2013 issue)

It says something about the lunatic calculus of Europe’s monetary union that the Republic of Cyprus, a slice of a Mediterranean rock known mainly, if not always fairly, for sunshine, no-questions-asked banking for murky Russian money, and a history of ethnic conflict, has shared a currency with Germany for the past five years. And it says perhaps even more that in 2010 and mid-2011 its two largest banks passed EU-wide “stress tests” that, revealingly and not so revealingly, hugely downplayed the risks that banks were running with their holdings of government bonds. And, yes, those two Cypriot banks had a lot of government bonds — Greek-government bonds — and a great deal of other business in the hard-pressed Hellenic Republic besides. Wait, there’s more: Together those two banks in 2011 had assets equivalent to over four times Cyprus’s GDP. Overall the country’s banking sector had assets that amounted to more than eight times GDP. What cannot go on, won’t. By the second half of 2011, Cyprus was in the grip of a growing financial crunch.

After securing an emergency loan of € 2.5 billion from Russia, Cyprus’s former AKEL government (“Communists,” but not really) turned belatedly, in June 2012, for help to the bailout-hardened troika of the European Commission, European Central Bank, and IMF. Negotiations dragged. It took the election of the new center-right president, Nicos Anastasiades, in February finally to break the logjam. Anastasiades had a clear mandate to agree to structural and budgetary reforms of the type that the troika was looking for, but he balked at demands that depositors with Cyprus’s banks share in the pain. The longer-term consequences for Cyprus’s banking sector, a mainstay of his nation’s economy, would, he knew, be disastrous.

That was not something that worried Angela Merkel. She was said to have said that Cyprus “must realize its current business model is dead.” Helping out the banks in an offshore tax haven was never a proposition likely to appeal greatly either to the chancellor herself — no friend of international finance at the best of times — or to German voters. They are due to go to the polls in September. After years of bailouts that they never liked and that were designed to rescue a currency that they never wanted, there was an obvious danger that coming too generously to the aid of an oligarchs’ playground would be a handout too far. And so Germany played a major role in insisting that any bailout be accompanied by a “bail-in” that would shift a good part of the cost of a rescue onto depositors with Cyprus’s banks.

The Cypriots caved. The euro-zone nations and the IMF would together provide € 10 billion in new loans, but depositors in Cyprus’s banks would have to chip in too, a grim first in the grim history of the euro-zone bailouts. Deposits of over € 100,000 would be subject to a one-off tax of 9.9 percent. Then came an additional, dangerous twist. Depositors with less than € 100,000 would also be taxed — in their case, at 6.75 percent, a levy that made nonsense of the understanding that, within the EU, such smaller deposits are meant to be insured. That breach of faith could easily be seen as an unsettling precedent, especially elsewhere in the euro zone’s troubled periphery.

The Cypriot leadership probably chose to penalize the smaller fry in this manner because they worried that taking too much from the high rollers risked damaging what was left of Cyprus’s offshore-banking business, but it created such an uproar — on the island and beyond — that its overwhelming rejection by the Cypriot parliament a few days later came as a surprise to no one.

It was back to the drawing board. What emerged on the second go-round a few days later was structured somewhat more sensibly. Bank deposits of less than €100,000 are protected, but Cyprus’s second-biggest bank, Laiki, will be restructured out of existence, quite possibly wiping out all uninsured deposits on the way. Its larger rival, the Bank of Cyprus, has been rescued, but this will come as cold comfort to its major depositors, who are likely to end up taking a shellacking so brutal that there will be little to choose between their fate and that of their counterparts at Laiki.

The good news was that this kept the troika committed to the €10 billion loan. That would, said Anastasiades, be enough to stave off bankruptcy. More modest than most euro-zone politicians, he did not claim that his particular chapter of the currency union’s interminable crisis was over, merely that it had been “contained,” an idea echoed by the fact that draconian “temporary” controls on the movement of money out of the country have been put in place. Even so, the president was being too optimistic. The banking sector is shrinking rapidly. Many other businesses have been badly damaged by the calamities of recent weeks and are now facing the prospect of operating in a near-siege economy — conditions that are, in addition, unlikely to attract the foreign investment that Cyprus will now desperately need. Making matters worse still, money will leak out, despite the controls. GDP will contract sharply, perhaps by as much as 20 percent over the next couple of years. Unemployment will soar.

With the economy in free fall and government debt-to-GDP set to rise to some 140 percent after the bailout, it will take a miracle for Cyprus to avoid a return to the begging bowl — a miracle so far-fetched that even Cyprus’s most senior cleric, Archbishop Chrysostomos II, cannot believe in it. The influential archbishop, admittedly long a strong nationalist, is urging abandonment of the euro, which would trigger the nation’s outright default. That won’t happen for now. Anastasiades has pledged to stick with the single currency. A majority of his fellow citizens are probably behind him in that, at least for the moment, for reasons that are easy to guess. A reversion to the Cypriot pound would mean a devaluation that would wipe out much of what’s left of the republic’s shredded savings, threaten massive inflation, and further disrupt an economy that has already lost its bearings. But the argument is not all one way: There’s a decent case to be made that an eventual exit from the single currency would, for all the pain, be the best possible way of repricing Cyprus back into the global economy. This is a debate that is far from closed.

In any event, the most intense phase of the Cypriot storm appears to have subsided for now, but it has left the euro zone even more battered than before. The two most dangerous threats to the survival of the currency union in its current form are a massive bank run and voter revolt. The disaster in Nicosia has made both more likely.

Let’s start with the banks. Depositors throughout the currency union have now been given a sharp lesson. Deposits above € 100,000 are riskier than they had previously assumed, a message reinforced by a series of comments from various euro-zone leaders who in the wake of the Cyprus deal, despite some hemming and hawing, made it clear that a new template is being put in place. Large depositors, bondholders, and other sources of wholesale money to a euro-zone bank are being warned that they should expect to take a hit if that bank runs into trouble. Properly tweaked, that’s a good principle — moral hazard and all that — but, with confidence in the euro zone and its often undercapitalized banks still shaky, now was not the moment to assert it. That was especially so in a week that had seen the introduction of strict controls on the free movement of capital — supposedly temporary (time will tell; precedents are not encouraging) — within a currency union that had allegedly consigned such restrictions to history.

This will mean that banks seen as vulnerable (or banks located in countries seen as vulnerable) will find it even more difficult — and more expensive — to attract funds. (Well, would you deposit more than € 100,000 with an Italian bank?) This is a perception that feeds upon itself, and, in the right wrong circumstances, can easily set the stage for panic. Even those with (supposedly insured) deposits below € 100,000 will have been left uneasy by those few days in which it appeared that the euro zone’s leadership was prepared to go along with a deal in which smaller depositors took a hit. Since then, there have been repeated reassurances that such deposits are safe. Protesting too much? Just maybe, and there’s no getting away from one uncomfortable truth: Those insured deposits are guaranteed at the national level, not by the euro zone as a whole. A guarantee is only as good as the guarantor. Insured depositors in Greece have, therefore, to hope that, in the event of a crisis, the Hellenic Republic is good for the money, or at least for a third bailout.

One possible, partial response to that part of the problem would be to institute a deposit-insurance scheme jointly guaranteed by all euro-zone members, but that would risk inflaming the source of the second great threat now stirring within the euro zone: democratic politics. One reason that deposit insurance has not expanded beyond national borders is the suspicion, most notably in Germany, that signing up for a broader European scheme would be signing yet another blank check, something that would be not only bad housekeeping but a quick way to antagonize the voters. The bailouts have long been unpopular among the electorate in the euro zone’s (reasonably) solvent north, but the eurofundamentalism of most of its political class has meant that, despite some heroic efforts in Finland, this sentiment has done little to derail the trainloads of cash and commitments heading toward the currency union’s embattled periphery.

That’s not to claim that relatively frugal sorts such as Chancellor Merkel have enjoyed making the handouts. They have not. The tough line that they are taking on Cyprus and, by extension, on banks throughout the euro zone is clearly intended to show that there are limits to their generosity with their taxpayers’ money and to the risks that they are prepared to take with their voters’ patience. In a recent poll, some 26 percent of German voters said they “could imagine” voting for a party that was opposed to the single currency. In late February, a new, achingly moderate center-right party, Alternative für Deutschland, was formed to appeal to just such voters. AfD won’t win, but if it takes even a few percentage points in September’s vote, it could make the election rather closer than Mrs. Merkel would like. She won’t want to give AfD any more ammunition than she has to over the next few months, which is just another reason to think that the next bailout drama (keep an eye on Slovenia) may be even uglier than the last: Bank depositors in the euro zone’s other struggling regions will, doubtless, be watching carefully — and anxiously.

But while politicians in the euro zone’s north have to contend, for the most part, only with the threat of voter revolt, those in the periphery have to contemplate dealing with far tougher opposition. If parliamentary approval for the final memorandum of understanding that seals the deal is required, there may be some sweaty interludes in Cyprus (the parliament’s speaker has already signaled his opposition), but the best guess must be that Cypriots are likely to be too traumatized to do anything but go along with the terms of their rescue for now. But the spectacle of their pauperization will not play well with their kin in Greece, already radicalized by years of slump and increasingly hostile to the idea of sticking with the painful austerity that many of them regard (not always completely incorrectly) as self-defeating. That austerity is the price of continued support from the north, not least because, without it, voters in Finland and elsewhere would likely finally say that they had had enough. Rock, meet hard place. For now the somewhat unwieldy Greek coalition government is sticking to the troika’s script, but its leaders can read the opinion polls — and their message of growing anger — as well as anyone else. Meanwhile, in Italy the success of Beppe Grillo’s insurgent (and anti-austerity) Five Star Movement (M5S) in the February elections has led to political paralysis. At this writing, there is still no government in Rome, and the prospect of new elections cannot be ruled out. M5S continues to ride high in the polls. The humiliation of Cyprus will be unlikely to have hurt its case. Meanwhile, Silvio Berlusconi’s PDL, itself deeply skeptical of the troika’s agenda, is also polling well. In the aftermath of the Cypriot deal, Italian bond yields rose, and Italian bank shares fell.

To repeat myself, if you had a deposit in an Italian bank, what would you do?

Tick tock.